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Breaking the Buck:
The Underlying Issues of the Sub-Prime
Crisis and Credit Crunch
Initially published October 22, 2008Revised April 22, 2010
Prepared by:
David Justin Ross
Chief Investment Officer
Radiant Asset Management, LLC
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Breaking the Buck:
The Underlying Issues of the Sub-Prime Crisis and Credit Crunch
The Credit Crunch
The credit crunch that began with the sub-prime mortgage market has spread to funds that were
supposed to be safe places to keep short-term cash. Many short-term bond funds, ultra-short-term
bond funds, and money market funds have been adversely affected, some of them disastrously, by the
infection from the sub-prime melt-down. The current credit market problems have many causes but
three events converged into a perfect storm in late 2007 that not only worsened the crisis, but spread it
to other, supposedly safer credit vehicles.
1. The Sub-Prime Crisis The market has discovered that packaging a collection of high-risk mortgagesinto a Structured Investment Vehicle (SIV) does not make them any less risky. It just makes the
crunch worse when it comes. The incidents of default in these SIVs have been far worse than actual
defaults on mortgage payments, even in the sub-prime space. Many funds and banks that
purchased these SIVs attracted by their promised returns have been forced to liquidate their
holdings under duress, further deepening the crisis.
As housing prices fell and the credit crisis has deepened, sub-prime borrowers with adjustable rate
mortgages (or worse, with large balloon payments) found that much or all of the equity in their
houses had evaporated, making it impossible for them to refinance. When they defaulted, their
foreclosed houses glutted the market, causing other sellers to have to drop their prices. This led to
lower assessed valuations, helping to deepen the crisis and extend it beyond the sub-prime space.
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While these defaults were only a relatively small (though much higher than normal) fraction of even
sub-prime mortgages, they had an outsized effect on the securities that were based on them.
2. FASB Rule 159 This rule, promulgated in November, 2007, mandated, among other things, thatLevel 2 and Level 3 securities be priced by their holders based on observable inputs if such were
available. Level 1 securities are continually marked- to-market (priced) and trade based on liquid
real prices. Level 2 are generally marked-to-model where there may be an observable input (such
as initial purchase price) but where there are no available quoted prices. Level 3 are valued on
unobservable inputs that reflect a companys own assumptions about validation. In May, it was
Fannie Mae estimated that 23 percent of its entire holdings were in Level 3 assets1
.
Companies purchased Level 2 and Level 3 securities based on their anticipated cash flow, and since
that cash flow was their primary interest, the ability to mark these securities to market was
considered unimportant. Not only was it difficult (or impossible) to do so, but evaluating these
securities based on a model (Level 2) or guesswork (Level 3) meant that their value didnt change
very often which produced a smooth NAV for the holding fund.
FASB 157 made it much harder for Level 2 (and some Level 3) holders to maintain the fiction of fixed
asset value. It requires them to price their holdings based on observable inputs, meaning
anything they could use to get a price closer to actual market demand.
Presciently, Paul Kedrosky2 said just before the rule came into effect, [I]t's hard not to wonder if
FASB Rule 157, which comes into force this Thursday, will turn out to be the fire that lights the final
fuse here. While it's laudable and all to force transparency and push market pricing, when everyone
1Freddie Mac Accounting Cuts Losses by $2.6 Billion, Bloomberg.com, May 14 2008.
2Credit Markets, Minsky Moments, and FASB Rule 157, paul.kedrosky.com, November 13, 2007.
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is forced to find a market price for illiquid instruments simultaneouslyduring a credit crisis the
result is a regulation-imposed death-spiral, with devastating implications all around.
3. Observable Inputs The use of these for valuing securities were mandated by the FASB rulechanges of late 2007. Markit Group was among the first to introduce these for mortgage-backed
securities with their ABX derivatives indices. The ABX was launched in January 2007 to serve as a
benchmark for securities backed by mortgages issued to borrowers with weak credit and therefore
to provide visibility and transparency in the pricing of sub-prime-backed securities. In doing so, it
gave a way of estimating the value of these securities.
Figure 1 shows the relative value (in the
second half of 2007) of derivatives on BBB-
rated mortgage securities written in the
first half of 2007. BBB securities are the
top of the sub-prime category. It is worth
noting that the index starts at 100 when
the mortgages are written.
Since neither the mortgages themselves nor the SIVs traded often, there had no need for their
holders to attempt to determine their fair value for carrying on their books. Derivatives on the
mortgages, however, did trade3. These indices therefore offered a way of valuating the holdings
that met Rule 157 requirements. A vicious cycle resulted. Using the values of the indices, holders of
the SIVs were forced to downgrade the book value of their holdings. This, in turn, reduced the
demand for derivatives based on those SIVs, which further depressed the index.
3Ibid.
Figure 1 BBB-rated mortgage securities
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To make matters worse, in August 2007, again in November, and yet again in early 2008, hedge
funds and banks were forced into massive asset liquidations. These assets included mortgage- and
asset-backed securities, CDOs (Collateralized Debt Obligations) and credit default swaps. This sale of
securities at distressed prices created more observable inputs in pricing and further
deterioration in the indices. This, in turn, caused asset revaluation at all levels and ever greater risk
aversion across the credit markets.
Many of the SIVs have lost 90% or more of their value during this period. Since default rates in the
mortgages upon which they are based are nowhere near this extreme, the joke that the problem
here was that someone asked what these securities was actually worth contains more than an
element of truth. It does no good to force the sudden valuation of a security if that valuation leads
to panic selling of the security, destroying its value.
While some funds liquidated, others tried different approaches. Some, perhaps figuring that Level 3
securities were less likely to be forced into a pricing situation, restated much of their Level 2
holdings as Level 3. Others, in part out of fear that their own forced sales would create observable
inputs for other securities in their portfolios, delayed selling, only to find that in many cases the
market for their holdings had dried up entirely.
The situation was exacerbated when the distressed sales led to events of default. These were not,
in general, a default in the underlying security (though there were certainly some of those). Instead,
funds that were restricted to holding securities above a specified credit rating suddenly found their
holdings downgraded. They had to liquidate these holdings, further depressing prices and
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swamping what few buyers remained. Many discovered the down side of ultra-short-term debt:
frequent rollovers are a problem in the absence of purchasers for those rollovers.
Funds that were negatively impacted as described above had been attracted to the securities by
their relatively high cash flow. They believed that by pooling the assets, default risk could be
minimized. Also by keeping them short-term, interest rate exposure could be minimized. As long as
the risks were borrower-specific an issue here, a company there this strategy worked. These
funds discovered however, that diversification evaporates in a crisis. As the credit crisis hit and
investments started to fall in value, investors rushed to withdraw their funds. To raise the necessary
cash, the funds were forced to sell already distressed assets into a market that was not interested in
buying them.
A recent Morningstar article stated, The roots of [these] problems shouldn't come as a surprise to
readers. Like beaten-up funds in other categories, many ultra-short funds own securities tied to the
performance of the housing market and, as it became clearer that that area was running into
trouble, these bonds started flailing. A key force in this downdraft is that heaps of investors
including hedge funds that had owned these securities had to sell them to stay afloat, which further
depressed their prices4.
As banks and funds liquidated their holdings, the infection spread. This negatively affected
securities only distantly touched by the sub-prime crisis. Eventually even Fannie Mae and Ginny
Mae backed securities found themselves out-of-favor. This, of course, badly affected the asset value
of the funds that held them, including several cash management funds. Even some money market
funds either broke the buck or had to be bailed out by their owners.
4Paul Herbert, Morningstar.com, April 21, 2008.
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Figure 2 Homestead Bond Fund cash management
breakdown as of 12/31/09
Source: Homestead Bond Fund
The Landscape
In the tradeoff between market and interest rate risk on the one hand and default risk on the other,
cash management funds have generally chosen to minimize the former while taking on more of the
latter than perhaps they realized. Exposure to longer-term securities carries exposure to the following:
1. Market /Allocation Risk The securities may find themselves with diminished demand, a situationthat was believed more likely for longer duration securities.
2. Interest Rate/Duration Risk Other than default, the primary risk to the value of debt instrumentsis a change in interest rates. A rise in interest rates tends to depress the value of debt and the
longer the duration, the greater the depression.
Cash management funds traditionally have deemed duration risk and market risk of primary importance
and consequently preferred very short-term instruments, even those with higher default risk. Because
these instruments were rolled over frequently, their exposure to interest rate changes was low. Holders
also believed that by pooling their investments they could cut their exposure to default risk while
maintaining an attractive return.
Consequence Examples
An example of a cash management fund is the Homestead
Short-term Bond Fund (HOSBX $225 million). Its holdings
are typical of many funds in this class. It holds securities
with maturities of three years or less. It invests in US
Government securities as well as corporate bonds and
other instruments. Figure 2 shows a breakdown of their
recent holdings.
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Figure 4 - SWYPX Total Return net of fees (3/1/07-8/31/08)
Source: Yahoo Finance
At least 95% of the funds assets must be in AAA, AA, or A
rated bonds. This relatively conservative investment
strategy has protected them some from the worst of the
credit crisis, but their net asset value has been
significantly and negatively impacted as Figure 3
demonstrates. All charts in this report reflect total
return net of fees.
Two funds that have been more strongly affected by the credit crisis were provided by two of the largest
names in the investment business: Charles Schwab and State Street.
Charles Schwab Yield Plus is a large (more than $600 million in mid-2008, currently $133 million) fund
(SWYPX) that invests primarily in investment-grade bonds. It may, however, invest up to 25% of its
assets in bonds below investment quality, provided they have no lower than a B rating from one NRSRO.
Their investments must have a duration exposure of
one year or less. The Schwab Yield Plus fund is an
excellent example of a cash management fund that
found the higher yields of lower-grade bonds
attractive. For a cash management fund, the results
were disastrous, as Figure 4 shows. The difficulties
began in August, accelerated in November, and
became truly severe in March.
Figure 3 HOSBX Total Return net of fees
(3/1/07-8/31/08)
Source: Yahoo Finance
TotalReturn
(Netoffees)
TotalReturn
(Netoffees)
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As the fund deteriorated in value, so did its assets under management. Although the fund has nominally
lost about 33% of net asset value, its holdings have declined by nearly 80% during this period. See
Figure 5 for the Total Return results. Schwab Yield
Plus was not the only supposedly safe fund to be hit
hard by the credit crunch. The State Street Yield Plus
short-term bond fund is another example. SSYPX
aimed for high current income and liquidity. It invested
in mortgage-backed securities, corporate notes, conduit
debt instruments, and various asset-backed securities, as well as derivatives of the above. It was shut
down at the end of March 2009.
Much larger than State Streets fund are Fidelitys Ultra-Short Bond Fund (FUSFX $310 million) and JP
Morgans Ultra-Short Duration Bond fund (JUSUX 275 million). Both have stated investment processes
that are more conservative than State Streets or Schwabs. FUSFX seeks a high level of current income
consistent with preservation of capital. It invests 80% of the fund in investment grade securities or
repurchase agreements for those securities. 25% or more of its assets may be invested in the financial
services industry. Its investments have a targeted average maturity of two years or less.
JUSUX has a similar profile, investing in bonds, money market instruments, adjustable rate mortgage-
backed securities, and municipal bonds. It targets a 1-year interest rate sensitivity. As the chart below
shows, these investments turned out not to be quite as conservative as Fidelity or Morgan intended.
JUSUX has lost nearly half its assets under management (through withdrawals and decline in NAV) since
mid-summer. See Figures 6 and 7 below.
Figure 5 - SSYPX Total Return net of fees (3/1/07-
8/31/08)
Source: Yahoo Finance
TotalReturn
(Netoffees)
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Figure 6 FUSFX Total Return net of fees (3/1/07-
8/31/08)
Source: Yahoo Finance
Figure 7 - JUSUX Total Return net of fees (3/1/07-
8/31/08)
Source: Yahoo Finance
Figure 8 - TGSMX Total Return net of fees (3/1/07-8/31/08)
Source: Yahoo Finance
An excellent example of the spread of the credit infection upstream in mortgage -backed securities can
be seen with TCWs Short-Term Bond I fund, TGSMX, see Figure 8 for Total Return. Its mortgage-backed
securities are guaranteed by, or secured by collateral guaranteed by the US Government or its
sponsored corporations (Fannie Mae and Freddy Mac). It also invests in AA or higher privately issued
mortgage backed securities. It has assets of more than $100 million. Average duration exposure is one
year.
A November 20 article in Kiplinger5touted TCWs Short-Term Bond fund as a fund that was weathering
the crisis, bolstered by its Government-backed securities. The article stated that the fund has behaved
just as you would expect an ultra-short bond fund to behave. The fund has delivered a modest yield
with virtually no movement in share price. The article also said, somewhat more presciently, If the
U.S. housing market collapsed and the backing of Fannie or Freddie became problematic, the TCW fund
would fall hard. But for now, its triple-A mortgage
investments are honest triple-As for the most
part. As Figure 8 shows, even Government
backed securities were not immune to the
collapse, though they fell later and not as hard.
5Ultra-Short: Still Ultra-Safe?, Kiplinger.com, November 20, 2007.
T
otalReturn
(Netoffees)
TotalReturn
(Netoffees)
TotalReturn
(Netoffees)
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Figure 9 - ASTIX Total Return (3/1/07-8/31/08)
Source: Yahoo Finance
As money market rates have fallen and the asset value of many cash management funds has been hit
hard, two classes of cash management funds have weathered the storm relatively well: ultra-short-term
government-only bond funds and funds investing in variable rate mortgage-backed securities. As Paul
Hebert said in the abovementioned Morningstar article, investors wondering where to put their near-
term money today have a few options. For the most risk-averse, it makes some sense to revisit money
market funds. They won't lose money, and they'll leave folks a bit better off than if they held their
money in a checking account. Given the low level of rates today, they won't be much better off, though.
Plus, not all ultra-short funds deserve the brush off that the worst of the lot do. Ultra-short government
funds and those focusing on adjustable-rate mortgages have done their jobs during the past several
months. We're fans of funds such as those offered by AMF, for instance.
AMFs Short US Government fund (ASITX $64 million) seeks a high level of current income consistent
with preservation of capital and the maintenance of liquidity. It invests only in high-quality fixed and
variable rate assets, primarily of US Government obligations. It targets durations between 1 and 3
years, but has restrictions on neither the minimum nor the maximum maturity of its holdings.
Unfortunately, since the Morningstar article was published, the infection has spread, as the chart below
shows. ASITX has lost half its assets under
management, mostly through withdrawals, see
Figure 9. Nonetheless, the loss of NAV has been
less than in funds with considerable subprime
exposure. We discuss those funds in the next
section.
TotalReturn
(Netoffees)
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Figure 10 - SHY Total Return (3/1/07-8/31/08)
Source: Yahoo Finance
Starting in August, 2007, investors started pouring hundreds of billions into money market and cash
management funds that invest in Government-only securities. According to an August report of
iMoneyNet Inc. in the last week of August alone, money-market investors overall poured $50 billion
into these Treasury- and government-only funds, while pulling $21 billion out of so-called prime money
markets, which can invest in other securities.
US Government-Only Funds
This brings us to the funds that invest solely in US Government securities and their derivatives. These
funds are limited to a specific range of maturities. Their past years performance is a strong indicator of
the security of the Government only approach.
Among the recipients of the cash pulled from other funds are various ETFs that seek to match the total
return of various duration Treasury products, see Figure 10. Among the largest is iShares Lehman 1-3
Treasury Bond ETF (SHY). It has more than $9 billion in assets. It seeks results approximating the price
and yield performance of the short-term US
Treasury market as defined by the Lehman
Brothers 1-3 Year US Treasury index. It
generally keeps 90% or more of its assets in
the bonds of the underlying index and at
least 95% of its assets in products of the US
Government. It may also invest up to 5% of
its assets in repurchase agreements
collateralized by US Government obligations or in cash and cash equivalents.
TotalReturn
Netoffees
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Figure 11 - SHV Total Return (3/1/07-8/31/08)
Source: Yahoo Finance
Figure 12 - ITE Total Return (3/1/07-8/31/08)
Source: Yahoo Finance
Figure 13 - 10 Year Note Yield (3/1/07-8/31/08)
Source: Yahoo Finance
Very similar in performance is iShares
Lehman Short Treasury Bond ETF (SHV)
with $1.5 billion in assets, see Figure 11.
It seeks to match Lehmans Short US
Treasury Index (now Barclays Capital).
Lehman also offers a mixed intermediate
term (1-10 year) Treasury SPDR (ITE).
Its performance over the past year is
very similar to SHY and SHV. See Figure
12 for Total Return
The reason these funds have held up so
well, and the reason that considerable
money has moved into them, is that
the underlying securities have been far
less volatile than anything else during
this crisis. The benchmark ten-year
note has had a slowly-declining yield
during this period, a near-perfect
inversion of the price of ITE, see Figure
13.
TotalRetu
rn
(Netoffees)
TotalReturn
(Netoffees)
Ten
YearNote
Yield
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Conclusion
Perhaps the most important lesson is one that has to be periodically relearned: Their aint no such
thing as a free lunch. It is not possible, over the long term, to receive returns in excess of the risk-free
rate without incurring some risk. That risk may be well-hidden, but it is there. As holders of ultra-short
term bond and money market funds have discovered at their considerable cost, risk is not mitigated by
forming an aggregate of securities with the same risk profile. A bundle of sows ears is still not a silk
purse. In particular, the idea that pooling higher-risk mortgages would reduce overall risk has proven as
false as such risk-avoidance approaches have in the past. The effect of such risk pooling is to make the
crash, when it comes, that much worse.
An important takeaway is that while one must assume risk to get higher returns, risk that is predictable
is better than risk that is hidden. And aggregation tends to hide risk. On the other hand, funds that
invest in Treasuries and other guaranteed securities where the primary risk is interest rate change
exposure have fared far better than those that invested in asset-based securities. There is certainly risk
in interest rate exposure, but, as the market has sharply proven over the past several months, that
exposure is far more manageable and far more predictable than the risk of contagious default.
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About Radiant Asset Management, LLC
This paper was written by Radiant Chief Investment Officer, David Ross, who has a background in
applied mathematics and investment management with an emphasis on U.S. Treasuries-based stratgies.
It was developed both as part of the research effort to understand the events surrounding U.S. debt and
Radiant enhanced return U.S. Treasuries strategy. Mr. Ross previously has run three companies, holds
nine patents, received a BS in Physics from Yale University, did his MS and PhD studies in Aeronauticsand Astronautics at Stanford University and has an asteroid named after him for his mathematics work
at NASAs Jet Propulsion Laboratory in the Advanced Projects Group.
Radiant Asset Management is an alternative investment management firm formed on the belief
that corporate fundamentals, investor behavior, and market dynamics drive performance.
Original research and proprietary analysis set us apart. We seek superior absolute returns in all
markets.
If you have any comments on the paper, are interested in any further research or speaking engagements
please contact:
Eric Brown
O: 425.867.0700
M: 206.949.1842
Radiant Asset Management, LLC
15400 NE 90th St.
Suite 300
Redmond, WA 98052
Disclosure
This material is directed exclusively at investment professionals. The presentation is provided for
limited purposes, is not definitive investment, tax, legal or other advice and should not be relied on as
such. Investors should consider their investment objectives before investing and may wish to consultother advisors. Any investments to which this material relates are available only to or will be engaged in
only with investment professionals. Any person who is not an investment professional should not act or
rely on this material.
The information presented in this report has been developed internally and/or obtained from resources
believed to be reliable; however, Radiant Asset Management does not guarantee the accuracy,
adequacy or completeness of such information. References to specific securities, asset classes and/or
financial markets are for illustrative purposes only and are not intended to be recommendations.
All investments involve risk and investment recommendations will not always be profitable. RadiantAsset Management does not guarantee any minimum level of investment performance or the success of
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of loss. This material is not an offer to sell nor a solicitation of an offer to purchase any securities of
Radiant Asset Management or its affiliates. Radiant Asset Management and its affiliates are under no
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